chapter21 Accounting for leases.pdf

Slide 21-1

Bob AndersonBob Anderson-- UCSBUCSB

Accounting for LeasesAccounting for LeasesAccounting for Leases

Chapter

21Chapter Chapter

2121

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A Lease is a contractual agreement between a lessor and a lesseethat gives the lessee the right to use specific property, owned by the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payments (rents)..

A Lease Lease is a contractual agreement between a lessorlessor and a lesseelesseethat gives the lessee the right to use specific property, owned by the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payments (rents)..

Basics of LeasingBasics of LeasingBasics of Leasing

Lease termLease term

Lease Contract

Rental paymentsRental payments

Executory CostsExecutory Costs

RestrictionsRestrictions

NoncancelableNoncancelable

Early terminationEarly termination

DefaultDefault

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Advantages of LeasingAdvantages of LeasingAdvantages of Leasing

100% Financing at Fixed Rates100% Financing at Fixed Rates

Protection against ObsolescenceProtection against Obsolescence

FlexibilityFlexibility

Less Costly FinancingLess Costly Financing

Alternative Minimum Tax ProblemsAlternative Minimum Tax Problems

OffOff--Balance SheetBalance Sheet--FinancingFinancing

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Accounting by LesseeAccounting by LesseeAccounting by Lessee

Operating LeaseOperating Lease Capital Lease

Journal Entry: Journal Entry: Rent expenseRent expense xxxxxx

CashCash xxxxxx

Journal Entry: Journal Entry: Leased equipment xxxLeased equipment xxx

Lease obligation xxxLease obligation xxx

The issue of how to report leases is the case of substance versuThe issue of how to report leases is the case of substance versus s form. Although technically legal title does not pass in lease form. Although technically legal title does not pass in lease transactions, the benefits from the use of the property do.transactions, the benefits from the use of the property do.

Statement of Financial Accounting Standard No. 13, Statement of Financial Accounting Standard No. 13, ““Accounting for Leases,Accounting for Leases,”” 19801980

A lease that transfers substantially all of the benefits and risA lease that transfers substantially all of the benefits and risks of ks of property ownership should be capitalized (only property ownership should be capitalized (only noncancellablenoncancellableleases may be capitalized).leases may be capitalized).

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MechanicsMechanicsMechanics

The expense recorded on a capital lease and an operating lease are THE SAME over the life of the asset. In a capital lease it hits the P&L via interest expense and depreciation expense VS operating, it all goes into rent expense.

In a capital lease, think of it as a sale. The commitment to the lessor is a debt and should be treated like any other debt (current vs. noncurrent, accrue interest etc.) The asset gets depreciated just like if it were owned/purchased.

The expense recorded on a capital lease and an operating lease are THE SAME over the life of the asset. In a capital lease it hits the P&L via interest expense and depreciation expense VS operating, it all goes into rent expense.

In a capital lease, think of it as a sale. The commitment to the lessor is a debt and should be treated like any other debt (current vs. noncurrent, accrue interest etc.) The asset gets depreciated just like if it were owned/purchased.

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Compare capital vs. operating leaseCompare capital vs. operating leaseCompare capital vs. operating leaseFACTSLease a computer worth 3,000 Lease term 3 yrsAnnual payment 1,143 Estimated life of a computer 4 yrsEffective borrowing rate 7%

PRESENT VALUE OF PAYMENTS $3,000ANNUAL DEPRECIATION $750

CAPITAL LEASEEquipment 3,000 Cap lease obligation 3,000 Cash 1,143 1,143 1,143 Interest expense 210 145 75 0 Capital lease obligation 933 998 1,068 (0) Depreciation expense 750 750 750 750 Accumulated depreciation 750 750 750 750

OPERATING LEASERent expense NO OPENING ENTRY! 1,143 1,143 1,143 Cash 1,143 1,143 1,143

COMPARE EXPENSE OF THE TWO:CAPITAL LEASE OPERATING LEASE Interest expense 429 Rent expense 3,429 Depreciation expense 3,000

3,429 DIFFERENCE BETWEEN THE TWO OVERALL: NONE!!!!

OPENING YEAR ONE YEAR TWO YEAR THREE YEAR FOUR

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Capitalization Criteria Capitalization Criteria Capitalization Criteria

Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Leases that DO NOT meet any Leases that DO NOT meet any of the four criteria are of the four criteria are accounted for as Operating accounted for as Operating LeasesLeases

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TransferTransferofof

OwnershipOwnership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

The lease transfers ownership The lease transfers ownership of the property to the of the property to the lessee.lessee.

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TransferTransferofof

OwnershipOwnership

Bargain Bargain PurchasePurchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

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Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Lease term can be extended by Lease term can be extended by a a bargain renewal optionbargain renewal option..

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Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Three important concepts:Three important concepts: Minimum lease paymentsMinimum lease payments ExecutoryExecutory costscosts Discount rateDiscount rate

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Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Minimum lease payments:Minimum lease payments: Guaranteed residual valueGuaranteed residual value Penalty for failure to renewPenalty for failure to renew Bargain purchase optionBargain purchase option

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Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

ExecutoryExecutory Costs:Costs: InsuranceInsurance MaintenanceMaintenance TaxesTaxes

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Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Discount Rate:Discount Rate:Lessee computes the PV of the minimum

lease payments using the lessee’s incremental borrowing rate. (one (one exception)exception)

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REAL WORLDREAL WORLDREAL WORLD

The leasing companies are hip to these criteria and go out with a lease that they believe satisfies the requirements. They usually run really tight (i.e PV of payments is 89.9% of the fair value of the asset).

Just because the leasing company says it works as an operating lease, doesn’t make it so!!

The leasing companies are hip to these criteria and go out with a lease that they believe satisfies the requirements. They usually run really tight (i.e PV of payments is 89.9% of the fair value of the asset).

Just because the leasing company says it works as an operating lease, doesn’t make it so!!

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TEXT example from p.1097TEXT example from p.1097TEXT example from p.1097Lessor and Lessee sign a lease agreement dated January 1, 2005 which

requires Lessor to lease equipment to lessee beginning January 1, 2005. Terms are:

5 year, noncancelable lease term, equal annual payments at beginning of year of $25,981.62

Fair value of equipment is $100,000 at inception and has 5 yr. Life and no residual value

Lessee pays all executory costs directly, except property tax which is $2,000 per year and part of the annual payment of $25,981.62

No renewal options and equipment reverts to Lessor at termination Lessee borrowing rate is 11%, Lessor implicit rate is 10% and known

to Lessor Lessee depreciates on a straight line basis.

InstructionsInstructionsPrepare the journal entries on the books of the Lessee that relate to the lease agreement through December 31, 2009.

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p. 1097 SOLUTIONp. 1097 SOLUTIONp. 1097 SOLUTIONPayment 25,981.62 OPENING ENTRY:Property tax (2,000.00) Equipment 100,000 Lease portion 23,981.62 Capital lease obligation 100,000

Rate 10% * 1/1/05 ENTRY:Period 5 Lease liability 23,982 PV 100,000 Property tax expense 2,000 Life of asset 5 Cash 25,982

- * smaller of lessee borrowing rate or lessor implicit rate 12/31/05 ENTRY:

Interest expense 7,602 IS THIS A CAPITAL LEASE? YES- 100% OF LIFE IS>75% AND Pv of Payments>90% Depreciation expense 20,000

accum dep 20,000 LEASE AMORTIZATION SCHEDULE Accrued interest 7,602

LEASE LEASE - LEASE PMT INTEREST REDUX LIABILITY 1/1/06 PAYMNT:

1/1/05- OPENING 100,000.00 Property tax expense 2,000 1/1/05 PAYMENT 23,981.62 - 23,981.62 76,018.38 Lease liability 16,380 1/1/06 PAYMENT 23,981.62 7,601.84 16,379.78 59,638.60 Interest payable 7,602 1/1/07 PAYMENT 23,981.62 5,963.86 18,017.76 41,620.84 Cash 25,982 1/1/08 PAYMENT 23,981.62 4,162.08 19,819.54 21,801.30 - 1/1/09 PAYMENT 23,981.62 2,180.13 21,801.49 - ETC.

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RESIDUAL VALUE- LESSEERESIDUAL VALUERESIDUAL VALUE-- LESSEELESSEE

Accounting depends on whether the residual is guaranteed or not:

Not Guaranteed: As if it did not exist Guaranteed: As if the guaranteed amount is a final

payment (gain/ loss results on final payment depending on what the value of the property is)

Accounting depends on whether the residual is guaranteed or not:

Not Guaranteed: As if it did not exist Guaranteed: As if the guaranteed amount is a final

payment (gain/ loss results on final payment depending on what the value of the property is)

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BARGAIN PURCHASE OPTIONBARGAIN PURCHASE OPTIONBARGAIN PURCHASE OPTION

DISCOUNT THE BARGAIN! (if get 10 for 2, then what is the PV of the cost of the $8 bargain??

The cost= PV of the $2 payment))If there is a bargain purchase option, then you assume

it will be paid and the asset transferred at the end of the term. Think of it as a final lease payment. For instance- 3 year lease at $100 per year, 10% implicit rate. Can buy the item for $75 at the end of the term when it’s fair value would be $150. Then the PV of the payments is:

PV of lease payment $250PLUS PV of $75 in the future $ 56PV of the lease $306

DISCOUNT THE BARGAIN! (if get 10 for 2, then what is the PV of the cost of the $8 bargain??

The cost= PV of the $2 payment))If there is a bargain purchase option, then you assume

it will be paid and the asset transferred at the end of the term. Think of it as a final lease payment. For instance- 3 year lease at $100 per year, 10% implicit rate. Can buy the item for $75 at the end of the term when it’s fair value would be $150. Then the PV of the payments is:

PV of lease payment $250PLUS PV of $75 in the future $ 56PV of the lease $306

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IllustrationIllustrationIllustration

E21E21--22 Pat Delaney Company leases an automobile with a fair value of $8,725 from John Simon Motors, Inc., on the following terms:1. Noncancelable term of 50 months2. Rental of $200 per month (at end of each month; present value at

1% per month is $7,840).3. Estimated residual value after 50 months is $1,180 (the present

value at 1% per month is $715). Delaney Company guarantees the residual value of $1,180.

4. Estimated economic life of the automobile is 60 months.5. Delaney Company’s incremental borrowing rate is 12% a year (1% a

month). Simon’s implicit rate is unknown.InstructionsInstructions

Prepare the journal entries on the books of Delaney Company for the first month of the lease.

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Solution E21-2Solution E21Solution E21--22FACTSTerm of lease 50 monthsMonthly rent 200Rate 12%Guaranteed res. Value 1,180 Life of asset 60 months

This is a capital lease because two of the criteria are met (only need one met)

Lease term 50Life of asset 60

83% > 75% requirement

PV of payments (since residual is guaranteed, it is included)PV of payments $7,839.22PV of residual $717

$8,556.71

ENTRY TO RECORD:Leased equip under cap lease 8,556.71$ Lease liability 8,556.71$

1st Month Entry:Depreciation expense 147.53$

Accum. Dep 147.53$ Lease liability 114.43$ Interest expense 85.57$

Cash 200.00$ Slide 21-22


Benefits Available To The LessorBenefits Available To The Benefits Available To The LessorLessor

Interest RevenueInterest Revenue

Tax IncentivesTax Incentives

High Residual ValueHigh Residual Value

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Group I Transfer of ownership Bargain purchase option Lease term => 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property

Group II Collectibility of the payments required from the lessee is reasonably

predictable. No important uncertainties surround the amount of unreimbursable costs

yet to be incurred by the lessor under the lease (lessor’s performance is substantially complete or future costs are reasonably predictable).

Group I Transfer of ownership Bargain purchase option Lease term => 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property

Group II Collectibility of the payments required from the lessee is reasonably

predictable. No important uncertainties surround the amount of unreimbursable costs

yet to be incurred by the lessor under the lease (lessor’s performance is substantially complete or future costs are reasonably predictable).

Capitalization Criteria (Lessor) Capitalization Criteria (Capitalization Criteria (LessorLessor) )

Why Group II Requirements?

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LESSOR: DIRECT FINANCING VS. SALES TYPE LEASESLESSOR: DIRECT FINANCING VS. SALES TYPE LEASESLESSOR: DIRECT FINANCING VS. SALES TYPE LEASES

IF ALL THE CRITERIA ARE MET, THEN IT IS EITHER A DIRECT FINANCING OR SALES-TYPE LEASE TO THE LESSOR:

Direct Financing: Lessor is not making money from selling the product, they are in it for the financing aspect (more like a lender). It works just like the capital lease we just spoke of for lessee, but in reverse (interest income, lease receivable VS interest expense , interest receivable )

Sales-Type: Lessor is getting a financing fee, but ALSO is making money from the product itself as well (they may be a manufacturer or retailer). More complicated- need to deal with any profit the lessor is making from selling the asset.

IF ALL THE CRITERIA ARE MET, THEN IT IS EITHER A DIRECT FINANCING OR SALES-TYPE LEASE TO THE LESSOR:

Direct Financing: Lessor is not making money from selling the product, they are in it for the financing aspect (more like a lender). It works just like the capital lease we just spoke of for lessee, but in reverse (interest income, lease receivable VS interest expense , interest receivable )

Sales-Type: Lessor is getting a financing fee, but ALSO is making money from the product itself as well (they may be a manufacturer or retailer). More complicated- need to deal with any profit the lessor is making from selling the asset.

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Any Group 1Criteria Met?

Is AssetFMV >

Bookvalue?

YesYes YesYes YesYes

No

Operating Lease

Lease Agreement

No No No

Group 1 criteria are the four criteria Group 1 criteria are the four criteria that must be considered for that must be considered for capitalization of a lease by a lessee.capitalization of a lease by a lessee.

Direct Financing Direct Financing LeaseLease

SalesSales--Type Type LeaseLease

YesYes

Both

Collectibilityof PaymentsReasonably

Certain?

Lessor’sPerformanceSubstantiallyComplete?

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Payment 100 LESSOR- DIRECT FINANCINGperiod 3 rate 8%PV 258

FV 258 Cost 258

UPON "SALE"Cap lease receivable 258

Asset 258 YR 1Cash 100

Interest income 21 Cap lease receivable 79

YR 2Cash 100


YR 3Cash 100

Interest income 7 Interest income 93

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Payment 100 LESSOR: SALES TYPEperiod 3 rate 8%PV 258

FV 258 Cost 200

UPON "SALE"Cap lease receivable 258

Asset 200 Gain 58

YR 1Cash 100


YR 2Cash 100


YR 3Cash 100

Interest income 7 Interest income 93

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Is it possible that a lessor having not met both criteria will classify a lease as an operating lease but the lessee will classify the same lease as a capital lease?

In such an event, who will have the asset on their books?

Is it possible that a lessor having not met both criteria will classify a lease as an operating lease but the lessee will classify the same lease as a capital lease?

In such an event, who will have the asset on their books?


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Copyright Copyright ©© 2000 by Coby Harmon2000 by Coby Harmon

Capitalization CriteriaCapitalization CriteriaCapitalization Criteria

Transferof

Ownership

Bargain Purchase

Lease Term>= 75%

PV of Payments

>= 90%

Operating

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Discount Rate:Discount Rate:Lessee computes the PV of the minimum

lease payments using the lessee’sincremental borrowing rate. (one (oneexception)exception)

Documents

chapter21 Accounting for leases.pdf